CoCos with Extension Risk: A Structural Approach

A prohibition on incentive to redeem in capital regulation

“…In view of the above, earlier, the participants used to interpret a call-back option related to the increase in the interest as the actual maturity of the bond, as the call-back was bound to happen owing to the rising interest anyway. The lack of call-back used to be regarded as a fiduciary risk, as it suggested the investors that the issuer had funding problems (Corcuera et al, 2014).…”

Pricing CoCos with a Market Trigger

“…Indeed, from the definition of the random times τ and τ j (see (14)) and the barriers and j it follows that…”

“…Investing in such a contract has the inherent risk of a financial loss due to the lengthening of the (investor's) expected maturity duration which ultimately postpones the payment of the face value K. This risk is referred to as extension risk. Two recent papers [14,18] have addressed the problem of pricing CoCos belonging to the Additional Tier 1 capital category. As an illustration, let us revisit the Black-Scholes model in Sect.…”

“…As it turns out, the lower Snell envelope ( Y Hence we obtain Proof With the explicit description of the payoff corresponding to the CoCo with extension risk, the result is obtained as in Proposition 2, here taking into account the following identity In view of this proposition, the obtainment of a closed-form formula for the price CoCo with extension risk requires the knowledge of the conditional distribution of (τ, S T 0 , S T 1 , ..., S T i ) for i = 1, ..., N. In the Black-Scholes model, this can be achieved by means of the following general lemma obtained in [14].…”

“…This risk of extending the life of a contract is what we call extension risk. This has been treated for the first time in [18] using an intensity approach and in [14] using a structural approach.…”